Saturday, October 23, 2010

Ya feelin' lucky, punk?

John Hussman, PhD, is a good read, from time to time. His writing style is often dry and since he constrains his view of the economy to the big picture, he's not so frenetically following the many distractions of the day that a market trader might, so new themes and ideas develop slowing in his weekly diary. But, from time to time, he is well worth the read.

And this time, it is not only helpful, but he's actually got some life in his prose. Here are a few extracts.

The Recklessness of Quantitative Easing
In the movie Dirty Harry, Clint Eastwood growls his famous line "I know what you're thinking. 'Did he fire six shots, or only five?' Well, to tell you the truth, in all this excitement I kind of lost track myself... You've gotta ask yourself one question. Do I feel lucky? Well, do ya punk?"

Over the past two years, the Fed has emptied what has largely turned out to be a chamber of blanks. Its remaining credibility lies in the belief by the public that Bernanke still has a live round left to fire. Once the Fed engages in QE, a failure of appreciable improvement in U.S. employment and economic activity would result in a substantial loss of public confidence. The Fed would be wise to save whatever ammunition it has left for a crisis point when the U.S. public is in dire need of confidence.

An additional fruit of careless, non-economic thinking on behalf of the Fed is the idea of announcing an increase in the Fed's informal inflation target, in order to reduce expectations regarding real interest rates. The theory here - undoubtedly fished out of a Cracker Jack box - is that lower real interest rates will result in greater eagerness to spend cash balances.

Unfortunately, this belief is simply not supported by historical evidence. If the Fed should know anything, it should know that reductions in nominal interest rates result in a lowering of monetary velocity, while reductions in real interest rates result in a lowering of the velocity of commodities (commonly known as "hoarding").

A second round of QE presumably has two operating targets. One is to directly lower long-term interest rates, possibly driving real interest rates to negative levels in hopes of stimulating loan demand and discouraging saving. The other is to directly increase the supply of lendable reserves in the banking system. The hope is that these changes will advance the ultimate objective of increasing U.S. output and employment.

To assess whether QE is likely to achieve its intended objectives, it would be helpful for the Fed's governors to remember the first rule of constrained optimization - relaxing a constraint only improves an outcome if the constraint is binding. This policy will be ineffective because it will relax constraints that are not binding in the first place.

On the demand side, it is apparent that the U.S. is presently in something of a liquidity trap. Interest rates are already low enough that variations in their level are not the primary drivers of loan demand.

Businesses and consumers now see their debt burdens as too high in relation to their prospective income. The result is a continuing effort to deleverage, in order to improve their long-term financial stability. This is rational behavior. Does the Fed actually believe that the act of reducing interest rates from already low levels, or driving real interest rates to negative levels, will provoke consumers and businesses from acting in their best interests to improve their balance sheets?

On the supply side, the objective of quantitative easing is to increase the amount of lendable reserves in the banking system. Again, however, this is not a constraint that is binding. The liquidity to make new loans is already present.

Despite the probable lack of measureable benefits, further QE poses significant risks. It has already triggered a steep decline in the exchange value of the U.S. dollar, and threatens a destabilization of international economic activity, a loss of confidence, and the creation of a "boom-bust" cycle threatening to choke off any economic recovery that does emerge.

The Fed might like to believe that a cheaper dollar will improve trade by increasing U.S. exports and reducing imports. However, over the past two decades, and particularly in recent years, U.S. imports have been much more elastic in response to fluctuations in the U.S. dollar than exports have been. This suggests that provoking further dollar depreciation is likely to have negative effects on the global economy, owing to a shift away from imports, but with few positive effects for U.S. economic activity. Indeed, a further depreciation would unnecessarily create a negative wealth effect for U.S. consumers facing higher prices for imported goods and services. Any improvement in the trade deficit would be largely offset by downward pressure on U.S. consumption.

As a side note, some observers have suggested that QE represents nothing more than "printing money." While this might be accurate if the Fed never reverses the transactions, the most useful way to think about QE, in my view, is as an attempt to directly lower interest rates by purchasing Treasury securities. This interest rate effect - not any major inflationary outcome - is the cause of the dollar depreciation we are observing here. There is little doubt that the effect of large continuing fiscal deficits is long-run inflationary, but as I've noted repeatedly over the years, there is little correlation between inflation and temporary - even large - variations in the monetary base. Inflation is ultimately a fiscal phenomenon born of unproductive spending, regardless of how that spending is financed.

once the Fed has quadrupled or quintupled the U.S. monetary base from its level of three years ago, how will it reverse its position? Japan was able to successfully reverse its program of QE several years ago without much impact on yields, but unlike the U.S., it had the luxury of an extremely high savings rate. With nearly 95% of its debt held domestically, Japan had no need to resort to foreign capital. In contrast, over half of the U.S. national debt is held by other countries. Without a deep pool of domestic savings, and with no repurchase agreements in place, the Federal Reserve will eventually have to entice domestic and foreign investors to buy the Treasury securities back, pressuring interest rates higher, and virtually ensuring a capital loss.

Better policy options are available on the fiscal menu. Historically, international credit crises have invariably been followed by multi-year periods of deleveraging, but measures can be taken to smooth the adjustment. The key is to focus on the economic constraints that are binding. Presently, these relate to high private debt burdens, uncertainty about income, weak aggregate demand, and the reluctance by U.S. businesses to launch new projects.

Appropriate fiscal responses include extending unemployment benefits, ensuring multi-year predictability of tax policy, expanding productive forms of spending such as public infrastructure, supporting public research activity through mechanisms such as the National Institute of Health, increasing administrative efforts to restructure debt through writedowns and debt-equity swaps, abandoning policies that protect reckless lenders from taking losses, and expanding incentives and tax credits for private capital investment, research and development.

Throwing a trillion U.S. dollars against the wall to see what sticks is not sound monetary policy. By pursuing a policy that relaxes constraints that are not even binding, depresses the U.S. dollar, threatens to destabilize international economic activity, encourages a "boom-bust" cycle, provokes commodity hoarding, and pops off the Fed's last round of ammunition absent an immediate crisis, the Fed threatens to damage not only the U.S. economy, but its own credibility.

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